Secondary Markets — The Forgotten Exit Option

When the tech bubble popped in 2000, $1.8 trillion of capital evaporated into thin air. A few years prior, public market investors deployed large amounts of capital into any internet business they could get their hands on.

Not surprisingly, VCs truly benefited from the flood of IPOs; VC returns peaked in 1999 (Forbes: 10-year average IRR of 83.4% in 1999). Cash returned to LPs at increasingly faster rates, leading to a surge in the number of venture funds and the volume of invested capital.

Today, the large influxes of private money and inflating startup valuations are bringing back fears of yet another tech bubble. However, if one takes a closer look at the emerging trends in the industry, it is clear that investors are operating in a very different environment. Companies leveraging the reach, economic viability, and rate of expansion of new technologies are generating value quicker than ever before.

This has created a new investing landscape; VCs are competing to deploy significant amounts of capital at earlier stages and public market investors are entering the playing field. As a result, startups are staying private for longer and in turn traditional exit channels (M&A, IPOs) have contracted. However, as capital keeps flowing to tech startups and early stage VCs and employees increasingly look to cash out, a third exit option in secondary market sales is becoming a more viable and liquid alternative.

Understanding The Capital Influx This Time Over

The big difference today is that timing seems to be right; the decreasing costs of data storage and computing power have, in essence, made it easier and cheaper than ever for companies to (1) build products and get them to market (2) reach and acquire their target audiences, and (3) use massive amounts of data to improve their product strategies so as to extract more time and value out of their users.

Company Filings

At the same time, declining computing and storage costs means that explosive revenue growth can translate to enormous shareholder value.

Monetizing user bases is simpler than ever. For example, take a look at Snapchat’s monetization pace vs. Facebook and Google. Snap broke a million dollars in revenue within its first year of monetization.

Source: Snapchat Y+3 Projections (Goodwater); Company Data; Alrai Estimates

This is certainly not a surprise; mobile phones are becoming an integral part of our lives and advertisers are quickly transitioning their dollars to mobile-first platforms. In fact, mobile advertising is the fastest-growing segment of the advertising market today, expected to triple from $66 billion in 2016 to $196 billion in 2020 (IDC).

Mobile aside, startups leveraging the value of emerging tech platforms will monetize their products/services much more rapidly, more efficiently, and at very low costs. (Think applications running on Blockchain for its data storage and high uptime capabilities or consumer startups relying on 24/7 networks of self-driving vehicles)

Chris Sacca (who interestingly made his fortune buying-up Twitter secondary stock before its IPO) said it perfectly:

“Inflection points at which truly disruptive technologies need capital infusions are coming earlier and earlier and those deals have no patience to wait for the uninformed to catch up.”

Seems as though the “uninformed” are now pouring money into the space

Source: Bloomberg

Global venture-backed investment volumes grew from $35.5B in 2007 to $78.1B in 2015 (Bloomberg). This boom in venture money has mostly been driven by “tourist investors” (traditionally hedge fund and public market asset managers) who have recently entered the playing field and have given rise to the private IPO (funding rounds >$40M). According to Bloomberg, in 2015, of the ~$78.1B invested in private technology companies, 66% came from “tourists”, showing an exponential increase from a few years back.

The large influxes of private capital may also have propped up short and medium-term VC returns. The VC index outperformed both buyout and public market indices on a pooled horizon IRR basis on a 3 year time horizon.

Source: Cambridge Associates — Returns as of Sept. 30, 2016

The Repercussions of New Private Capital Inflows

Source: Pitchbook Data

(A) Drought in IPOs

In the past couple of years, the explosive growth in private market volumes has led to a drought in traditional exits and a surge in illiquidity of private company shares.

The IPO market took the biggest hit. After a boom in technology IPOs from 2011 to 2014 that saw an average of about 45 IPOs/year, the deal count suddenly collapsed to 23 in 2015 and 14 in 2016.

Source: Pitchbook Data

Entrepreneurs have been willing to stay private longer in part thanks to the flurry of private capital that has allowed them to expand their businesses and develop their products without having to deal with the short-term pressures of public markets and the added costs of securities regulation.

Company Filings

Though, it could be argued that Snap opened the gates for a flood of unicorn IPOs, public market volume constraints will certainly limit timelines to exit. Excluding crisis years (’02, 0'3, ’08, ‘09) the average total volume of tech IPOs proceeds per year stood at around $9B. If we compare this number to the total current market value of unicorns in the US today of ~$362B (assuming companies float ~15% of their market value) you would expect the public markets to take at least 5–6 years to digest the entirety of the cohort assuming they all go public.

There might be a silver lining here. Direct listings on public stock exchanges might smoothen the process for both startups and investors. In a direct listing, a company only lists secondary stock on the market without raising any new capital. This cuts down a lot of the time and costs associated with going public; investment banks are no longer needed as underwriters to market and sell the company’s new stock. Spotify is reportedly testing out the direct listing process in its upcoming IPO.

However, IPOs are still be unfavorable for most startups; Snap’s pump and dump post-IPO warned unicorn founders that public market investors are simply not tolerant to large bottom line losses. If Spotify can’t deliver on its 2017 profitability target and its stock gets hit the same way as Snap did, expect IPOs to continue slowing down moving forward.

(B) Reclining Growth M&A

Source: A16Z

Overall tech M&A volumes have steadily increased over time. The bad news is that A16Z’s managing partner Scott Kupor believes that the M&A VCs care about hasn’t grown much. He argues that most tech M&A volume in the past five years was driven by “consolidation” or “going-private” deals. These are large scale transactions very similar to the recent Dell-EMC merger that are aimed at consolidating a sector as opposed to growing it. “Growth” M&A deals (deals aimed at top-line revenue growth through product-line or geographical expansion for example) have more or less stagnated.

Kupor says that this is partly due to activist investors in public companies opting to spend their excess cash on large share buybacks and dividend plans. That in itself is a significant statement; who would have thought we could reach a stage where multi-billion-dollar share buy-backs and dividend plans become a standard opportunity cost to buying up technology companies?

In sum, exits are taking longer, while employees need their paydays, and LPs want to cash out. This creates a significant opportunity for secondary markets.

Source: Pitchbook Data

Secondary Investments As An Alternative Exit Option

In theory, secondary investments in private equity are very similar to what buying and selling stocks in the public markets consists of; one investor looking to liquidate his holdings exits to another investor who expects to make a positive rate of return on the asset. In practice, secondary investments in private equity can occur in two ways: direct transfers or LP buyouts.

(A) Direct Transfers

Just as in the public markets, secondary investments in private markets can be made by simply buying common or preferred stock directly from a current stockholder. The main requirement is to obtain sign-off from the board of directors as the transfer of stock would entail a change in the cap table, which is typically frowned upon. Today, direct transfers are nearly impossible to execute since most boards tend to have a strict policy against them. Facebook’s chaotic pre-IPO secondary transactions were a prime example of why boards today block secondary transactions. The volume of activity caused a lot of volatility in the company’s share price and may have profoundly influenced its IPO pricing.

However, direct share transfers do have a lot of pros; indeed, being a direct shareholder on the cap table of a company means that corporate information is completely transparent. It usually also yields an element of control for the purchasing investor. The current transfer process is quite onerous, but due to easing regulation from the JOBS Act (expanding the number of allowable shareholders in a company, less stringent filing requirements), the transactions will become much easier to execute.

(2) LP Buyouts

The second main method to get a secondary transaction done is through an LP transfer agreement (LP Buyout). Investors looking to buy secondary shares offer to buy out an existing LP of a fund that has a large percentage of its NAV allocated to the asset of interest. There are two main requirements to fulfill the transaction: the first one is a sign-off from the fund’s GP. The second one is an acceptance from the buyer to adhere to the existing LP agreements and requirements, which may include the payment of management fees and fulfillment of unfunded capital commitments by the selling LP (which is usually not the case though since most of these funds are near the end of their lifetimes).

Though it is much easier for investors looking to buy into secondary stock to transact through LP transfers, it has its downsides. First, a GP sign-off of an LP buyout request might send a wrong signal to the fund’s other existing LPs that chose not to (or could not) liquidate. Second, LP buyout investors obtain much less transparency on the performance of the underlying asset than do direct investors.

(3) Example Payout Structure

I modeled the expected returns on an Uber secondary investment. Assuming that we acquire common stock at a 35% discount to the last funding round (Series G) that occurred at a $68B EV, we would enter at a $44.2B EV, which would not be too far from the valuation of the two previous rounds (Series E at $40B). However, it is also important to note that since most of the underlying assets of secondary investments are common stock or preferred at the bottom of the preference stack, secondary investors usually have little to no downside protection in the event of a down round or liquidation.

The Current State of the Secondary Market

Source: Greenhill Cogent

Though traditional growth and late stage venture investors are still looking for liquidity preferences in their investments, we are going to increasingly see funds forgoing stringent terms for better entry points, hence driving more volume toward secondary investments. The current state of the secondary market suggests that this trend has started to play out. The total volume of secondary transactions increased fourfold from $9.5B to $40B from 2009 to 2015. Increasing volumes have also led to compressing discounts to NAV from around 37% in 2009 to 25% in 2015.

Up until Softbank’s $3B secondary deal in WeWork, we haven’t seen any large, notable secondary transactions that have gotten much public attention. However, volumes still seem to have discretely surpassed primary offerings.

Source: Insead Knowledge

Liquidity in secondary markets will continue to grow, fueled by the increasing supply of shares and investor demand for high-performing private technology companies. The good news for entrepreneurs and early-stage VCs is that secondaries are becoming a more liquid and established exit alternative.